Briefing note

Reducing low-income country risks The role of local currency-denominated from international institutions Jesse Griffiths, Ugo Panizza and Filippo Taddei May 2020

• Low-income countries, already facing significant challenges, now face a dramatic worsening of debt sustainability and the possibility of a widespread debt crisis because of the Covid-19 pandemic. Key messages • These countries are sensitive to external shocks partly because a large proportion of their debt is held in foreign currency and widespread devaluation of their own currencies has made their debt situation much worse. • The ability to borrow long term, internationally, in local currency could significantly reduce borrowing risks for low-income countries, but they would need help from multilateral institutions to do so. • This briefing outlines four options as to how low-income country debt risks could be reduced in a way that overcomes challenges, including the institutional rules of multilaterals, political economy problems and issues of moral hazard: 1. Multilaterals accept the currency risk themselves. 2. Multilaterals hedge lending through another institution. 3. Multilaterals borrow from local capital markets and on-lend. 4. Multilaterals borrow abroad and on-lend in local currency. • These options should be developed to generate workable proposals for discussion with low‑income countries, with a view to identifying how greater availability of local-currency funding could help them reduce debt risks. Purpose of this briefing will limit governments’ ability to cover existing expenditure and refinance their maturing debt. This briefing contributes to the discussion The large capital outflows, currency depreciation, on how to reduce debt risks for low-income fall in commodity prices and economic slump developing countries – an important issue in associated with the Covid-19 crisis are likely to recent years and now a policy priority as the lead to numerous debt crises. These problems are Covid-19 crisis escalates debt problems. It aims not due to policy failures in the developing world to identify and assess options for increasing the but to external factors, including skyrocketing supply of local currency-denominated lending by financing needs in advanced economies, elevated multilateral institutions to sovereign governments risk aversion among investors and the global in low-income countries, thus shielding them economic downturn. The severity of the crisis from risks associated with currency depreciation. in emerging and low-income countries has It is intended to promote debate and reinvigorate led to calls for widespread debt suspension or the consideration of serious policy proposals in cancellation, and the International Monetary this neglected but important area at a time when Fund (IMF) and G20 group of industrialised innovative ways of reducing debt risks for low- nations have taken steps in this direction. income countries are of paramount importance. From when the crisis exploded to 9 April 2020, more than 90 countries had requested or Background expressed interest in IMF support, around 60% of them low-income countries (IMF, 2020b). Public in low-income countries Capital outflows have led to currency has been rising since 2012. The median public depreciations, with significant effects on low- debt of low-income economies1 rose to 49% income countries where external debt makes up of (GDP) in 2019 from a major share of total debt. According to the 33% in 2013 (IMF, 2020a). The composition Institute for International Finance, between mid- of low-income country public debt has changed February and the end of March 2020, emerging dramatically in recent years, with declining economies registered record portfolio outflows concessionality and increased borrowing from totalling more than $100 billion (IMF, 2020c). private, non-traditional official and domestic To put this in context, total portfolio outflows in lenders. While the share of low-income country the three months after the 2008 global financial debt owed to private creditors had more than crisis were about $20 billion. The latest outflows doubled to nearly 6% of GDP as of 2016, have been associated with large currency the share of debt owed to bilateral creditor depreciations, which have averaged 15% in a members of the Paris Club was just over 2% of large sample of developing countries, but close to GDP. This compared with nearly 14% of GDP 30% in large emerging economies such as Brazil, owed to non-Paris Club creditors, with China Mexico, Russia and South Africa.2 Such big accounting for just over 4% of GDP. Domestic depreciations will have negative implications borrowing has been increasing, reaching more for debt sustainability in countries with large than 15% of GDP as of 2016, a level similar foreign-currency debt. Developing countries, to that borrowed from external multilateral including low-income countries, often have a creditors (IMF, 2018: 51). high proportion of debt denominated in external The Covid-19 crisis will have a massive currency, typically US dollars. In 2017, for effect on debt sustainability in developing example, an average 74% of low-income country countries. Higher healthcare costs, lower tax debt was denominated in a foreign currency and export revenues and frozen debt markets (Panizza and Taddei, 2020: 9). This is still the

1 There are several definitions of what constitutes a ‘low-income country’. We have used the IMF definition of ‘low-income economy’, as it is the broadest, encompassing 76 countries. All IMF citations refer to this grouping (IMF, 2020a: 46).

2 Authors’ calculations based on data from the Bank for International Settlements.

2 case, even though domestic debt levels have risen more than 15% of government revenues to debt significantly in many low-income countries. servicing in 2017, up from 21 countries in 2014 Partly as a result of this external currency- (UNCTAD, 2018: 7). denominated debt, low-income country debt As a result of increasing debt levels and the levels are particularly sensitive to external rising cost of debt, the number of low-income shocks. Debt sustainability analyses confirm countries facing serious debt problems was that the majority of low-income countries are already climbing rapidly and is likely to jump vulnerable to exchange-rate changes (IMF, as a result of the Covid-19 crisis. The IMF and 2015) and many are vulnerable to changes in World Bank debt sustainability exercise classified commodity prices. We saw sharp increases in 44% of low-income countries as being at high fiscal deficits, for example, following the 2015 risk of or already in debt distress – a number commodity-price shock (IMF, 2018: 39). The that has more than doubled since 2013 (IMF, rise of foreign participation in domestic capital 2020a: 14). Low-income countries are now markets means that the risks associated with more integrated into the global economy than changes in investor sentiment have grown before and, consequently, more exposed to (Cornford, 2018). Sudden capital outflows market risks because of their greater reliance caused by external investors’ withdrawal from on private borrowing (IMF, 2015). Foreign- domestic debt markets can lead to both sudden currency bonds are also more likely to involve changes in exchange rates and funding shortfalls bullet payments that lead to spikes in financing for countries relying on those markets (IMF, needs (IMF, 2015), increasing risks and, 2018: 50). The Covid-19 economic crisis is potentially, refinancing costs. These figures are on a scale not seen before, so the extent of the based on debt sustainability analyses conducted external shock to low-income countries will be before the Covid-19 crisis. The number of significant over the course of 2020 and beyond. low-income countries in debt distress or at The changing nature of public debt meant risk of debt distress is, therefore, likely to that it had already become more expensive and increase dramatically. volatile in low-income countries before the crisis. This was primarily due to an increase in debt Local-currency borrowing: a key tool owed to the private sector and an increase in for low-income countries domestic debt as a share of the total. Private debt tends to be significantly more expensive than The ability to borrow long term, internationally, alternative public lending from international in local currency could significantly reduce bilateral or multilateral sources and it is also borrowing risks for low-income countries and more pro-cyclical (Galindo and Panizza, 2018). help to reduce the likelihood of debt crises. Like Mark Twain’s proverbial banker, private As noted, the large currency depreciations that financiers stand ready to lend you an umbrella countries are experiencing have a dramatic when the sun is shining but want it back the impact on debt sustainability, largely because minute it starts to rain. As a result, debt-servicing they owe a considerable proportion of their debt costs are absorbing a growing share of public in foreign currencies. A recent study found that expenditure (IMF, 2018: 50), with yields spiking debt-to-GDP ratios tend to grow more rapidly in bad times. One analysis using IMF and World when countries that have a high share of foreign- Bank data suggests that the 124 developing currency debt undergo currency depreciation countries for which data is available spent a (Panizza and Taddei, 2020).3 Another advantage mean average 12.2% of government revenue on of long-term international borrowing in local debt servicing in 2018, up from 6.6% in 2010 currency is that it could provide an alternative to (Jubilee Debt Campaign, 2019). Another analysis borrowing from domestic debt markets. This is finds that 29 developing countries devoted especially useful in countries where domestic

3 Panizza and Taddei (2020) do not focus on maturity, but countries need to be careful not to currency mismatches for maturity mismatches.

3 sovereign borrowing levels are high or domestic the other side (borrowing), and vice versa. financial sectors are fragile. However, in low-income countries, a large Unlike some emerging markets, low-income share of lending by international institutions countries cannot normally sell their own local- is on a concessional basis, meaning there is currency bonds to international investors, so are a grant element that reduces the cost of the limited in their ability to borrow internationally lending. Thus, for example, a large share of the in their own currencies. There are two main concessional lending undertaken by the World reasons for this. First, credit and currency risk Bank’s International Development Association are higher in low-income countries, as these (IDA), which lends to low-income countries, economies are poorer and less diversified than is financed by grants that do not generate a large emerging markets. Second, there is a ‘fixed corresponding financial liability for IDA. Hence, cost’ involved in gathering information about IDA’s inability to assume currency risk should credit and currency risk, and international not be a constraint on foreign-currency lending. investors are only willing to pay this fixed cost It is also worth noting that IDA loans have if researching a new economy would allow them an average maturity of 20 years, and may be as to access a relatively large and liquid domestic long as 40 years, making an assessment of the market (for evidence, see Eichengreen currency risk very difficult (IDA, 2020). If the et al., 2005). In many low-income countries, is priced fairly, the only thing that matters is the domestic bond market is either small and the sharing of this risk, and if multilateral lenders illiquid or non-existent, as bonds are placed have higher risk-bearing capacity than the directly with domestic banks and there is no borrower, it makes sense that the multilaterals trading. This fixed-cost problem is amplified by should absorb some of this. the presence of market failures that prevent those Current risk-management practices do not who pioneer new markets and instruments from help either, as they assign higher capital charges getting all the gains of their market-discovery (which define how much capital the multilaterals process, as their activities can be easily copied by tie up) to domestic-currency loans. Therefore, later adopters. a higher share of domestic-currency loans would Low-income countries therefore need to rely reduce the amount of lending the multilaterals on international financial institutions to assist can undertake, shrinking the size of their them if they are to shift a reasonable portion of portfolios. However, these practices are not their international borrowing into local currency. written in stone and could be changed if there This could also help them to better manage the were the political will to do so. Another issue is scale of local-currency sovereign borrowing in that local-currency lending would complicate the domestic market. multilaterals’ asset-liability management There are, however, three main challenges and (Hoschka, 2005). Again, this is a technical issue objections to expanding local-currency lending that could be solved if there were the political by international financial institutions. will to move in this direction.4

The inability of multilateral financial Political economy problems and debt- institutions to accept currency risk management capacity in borrowing countries When these institutions provide ‘non- To borrow in local currencies implies paying a concessional’ or market-rate loans, their practice currency premium (ex ante) that incorporates the is to ensure that lending in domestic currency possibility of a sharp devaluation in future. This is offset by an equivalent amount of domestic- is analogous to buying insurance, where you pay currency borrowing. This helps to negate the a premium in good times so that you are covered currency risk, as any losses on one side of the should something go wrong down the line. Even portfolio (lending) are equivalent to gains on if the premium is set fairly (to precisely offset

4 For a discussion of technical challenges see Hoschka (2005), in particular the table on page 9, which lists domestic rating exemptions, broad investor access, risk weightings and reserve eligibility.

4 the currency risk), policy-makers who care more the discussion on how debt risks can be about the present are likely to disregard negative reduced. Examining ways to shift a proportion events that may materialise when they are no of international borrowing from external to longer in office. The probability of a currency local currency will be an important part of devaluation increases over time, so policy-makers that discussion. This paper, therefore, puts may find the premium expensive relative to the forward four options for how international short-term risks. This helps explain why they institutions might increase their share of would opt for foreign-currency debt with a local-currency lending in light of the obstacles lower and leave future governments highlighted and underscores the trade-offs that exposed to currency risk. Th issue is compounded will need to be carefully considered in taking by the fact that low-income countries tend to forward this agenda. have limited debt-management capacity. Hence, their debt managers may not fully appreciate the Options assessment costs and benefits of local-currency instruments with an embedded insurance component We evaluate four options for reducing the (Paesani and Piga, 2010). This is why capacity foreign-currency exposure associated with development is important. multilateral lending to low-income countries. These options focus on multilateral development Moral hazard bank operations and separate concessional from Increased lending in local currency could non-concessional lending. While these options generate incentives to reduce the real value of are not appropriate for IMF crisis lending, they debt by stoking . It is, however, worth could, in principle, be considered for the IMF noting that many economies have solved this Poverty Reduction and Growth Facility. problem by undertaking institutional reforms and creating a domestic constituency that Option 1: Multilaterals accept the currency favours low inflation. A recent study found no risk themselves correlation between local-currency borrowing Under Option 1, the multilateral simply retains and inflation, on average, but a correlation the currency risk by either making the loan in countries with weak institutions (Panizza directly in the domestic currency or transferring and Taddei, 2020). The authors of this study also foreign currency and requiring repayment in developed a simple but comprehensive model in foreign currency at the that is which monetary credibility was achieved with a prevalent when the loan is due. These two balance of foreign-currency and local-currency methods are theoretically equivalent. However, debt. Multilaterals could, therefore, balance from the lender’s point of view, transferring the share of their total lending in foreign and foreign currency and requiring repayment in domestic currency on a country-by-country basis. foreign currency is preferable for countries that Indeed, they would have to do this anyway to do not have a fully convertible currency. meet varying levels of demand. While taking on currency risk is problematic for multilaterals, local-currency lending does There is a long history of proposals for not violate the Articles of Agreement of IDA, significantly expanding multilateral local- which state that ‘the Association may provide currency lending to public actors in developing financing in such forms and on such terms as it countries. However, they have fallen off the may deem appropriate’. international policy agenda in recent years. There are various challenges and caveats Given the rising debt problems in low-income associated with switching IDA lending to local countries and the upsurge in debt associated currency, however. These are as follows: with the Covid-19 crisis, it is time to reinvigorate

5 • Even if the pricing is fair, local-currency run, the real exchange rate is less volatile than lending may lead to higher ex ante interest the nominal exchange rate). Adverse-selection rates or lower disbursements, so countries and moral-hazard concerns could be addressed may not be interested in switching to local- by ensuring that overall loan portfolios were currency borrowing for the political economy appropriately balanced between domestic and issues mentioned before. international currencies. While the political • Most countries receive positive net IDA economy problems brought about by short- flows,5 so the risk-sharing properties of sighted policy-makers would still exist, those local-currency lending are not as large as politicians should still be happy to borrow a they would be if net flows were negative. portion of their IDA allocation in domestic In this sense, local-currency lending would currency, given the highly concessional nature be particularly beneficial for countries close of the loans. In other words, while the ex ante to graduation. degree of concessionality would be lower, it could • Adverse selection (only countries that think still be large. that their currency will depreciate will apply for local-currency loans) and moral Option 2: Multilaterals hedge lending through hazard (countries with more local-currency another institution debt will have an incentive to debase their Making greater use of currency hedging tools currency) will have to be considered during might be another way forward. Hedging the lending process. products allow the currency risks of lending • Local-currency lending (and hedging, as in to be transferred to a third party, for a fee, Option 2) may require an additional ‘use’ without affecting the credit risk, which is of multilateral capital, limiting their lending retained by the lender. capacity. For example, The Currency Exchange Fund (TCX), backed by a large number of One way to allay the moral-hazard issue would multilateral and national development finance be to index the loan to domestic inflation, as institutions, has a long history of providing proposed by Hausmann and Rigobon (2003).6 hedging instruments for currencies that lack them This would have the additional advantage of in commercial markets (Hirschhofer, 2019).7 reducing long-run volatility and increasing the Such hedging products could be particularly predictability of IDA repayments (in the long interesting for regional development banks with

5 The exceptions are countries that are in the process of graduating out of IDA.

6 Hausmann and Rigobon (2003) argue that switching to inflation-indexed local currency would increase the likelihood of repayment (because the debt burden would be larger in good periods and smaller in bad periods), improve risk management for low-income countries and only have a minor overall impact the IDA portfolio’s dollar value. DePlaa and Yi (2005) find that switching to inflation-indexed local currency would, indeed, generate benefits for borrowing countries, as it would greatly reduce the sensitivity of the debt-to-GDP ratio to currency depreciation (according to their estimates, a negative shock to the exchange rate would increase the debt-to-GDP ratio by 0.39 standard deviations under current IDA practices and by 0.07 standard deviations under the Hausmann and Rigobon proposal). However, dePlaa and Yi (2005) find no benefit (but also no cost) to IDA’s portfolio diversification. While economic theory suggests that the real exchange rate of low-income countries should appreciate over time (the Balassa-Samuelson effect), dePlaa and Yi (2005) show that in 1985–2005, the real exchange rate of IDA countries depreciated and that an inflation-indexed local-currency lending programme would have reduced reflows by about $1 billion. This is not a large amount, considering that over the same period, IDA replenishments amounted to more than $100 billion.

7 TCX Fund investors include 24 multilateral and bilateral development finance institutions, a group of microfinance investment vehicles and the Dutch, German, Swiss and United Kingdom governments. Typically, TCX hedges are non- deliverable and settled in hard currency (so the counterparty bears convertibility risk). While TCX does not issue bonds, it promotes local bond-market development by hedging payments of local currency-denominated bonds issued by various development finance institutions.

6 limited internal diversification capacity, but currencies. Second, as is the case on domestic could also allow global institutions, such as IDA, markets, the local-currency pricing advantage of to experiment with local-currency lending in the multilaterals on the international market is a limited subset of countries. TCX operates in likely to be small. more than 90 developing countries. Before the Eichengreen et al. (2002) and Eichengreen coronavirus crisis, it aimed to provide around and Hausmann (2005) make a more interesting $3 billion in ‘exotic’ currency swaps in 2020 proposal. They suggest that the World Bank and to increase this to $7 billion in 2022 to and other multilateral development banks issue allow it to act as market maker, especially in the bonds denominated in a real (inflation-indexed) currencies of low-income countries (TCX, 2018). emerging-market currency index and use the TCX swaps have no tenor restrictions, so they proceeds to extend local-currency inflation- could also be used to support long-term loan indexed loans to their clients. This would have transactions. two advantages: (1) it would let the multilaterals The main challenge when it comes to hedging lend in local currency (albeit indexed to prices) is pricing. While it may be fair ex post, it could without taking on currency risk; and (2) it be considered too high or unaffordable ex ante. could create a market for such instruments, Borrowing countries could, therefore, require which could then be tapped by other types of a higher subsidy component in order to choose issuer. The main issue with this proposal is that a local currency-hedged loan over a standard the multilaterals would need to be careful in dollar-denominated IDA loan. In addition, all of matching their assets (single-currency loans) and the financial institutions that offer such products liabilities (indexed loans). are subject to potential threats to their business model when devaluations are widespread, as they Conclusions are at present. The international community and multilateral Option 3: Multilaterals borrow from local financial institutions must prioritise finding capital markets and on-lend ways to improve the debt sustainability of A third option is to for multilaterals to borrow low-income countries by reducing the level directly on local capital markets and then lend on of currency risk they face. We have looked at these funds to governments. This appears to be the workability of four proposed options in a less desirable option, though, as multilaterals terms of overcoming challenges and obstacles are unlikely to have a pricing advantage over and at how desirable they are for low-income governments in their own markets.8 Indeed, by countries. Options 1, 2 and 4 are all potentially entering in these markets, they risk crowding out useful and should be examined and developed the private sector in low-income countries with to produce workable proposals in collaboration shallow capital markets. with low-income countries. If low-income countries are to emerge from the current crisis Option 4: Multilaterals borrow abroad and and avoid potentially debilitating sovereign-debt on-lend in local currency crises, new mechanisms and ways of working Another alternative would be for multilaterals will have to be found to reduce their debt risk. to borrow internationally in the currencies of The development of local currency-denominated the borrowing countries. There are two issues loans by international institutions is one here. First, it may be difficult to convince important response and should be put back international investors to lend in exotic on the policy table.

8 In theory, the multilaterals should be able to borrow at cheaper rates than their clients, which have higher credit risk. In practice, this is rarely the case. Even when there is a pricing advantage in local-currency terms, this is much lower than the pricing advantage in foreign currency (Perry, 2009).

7 References

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